Why IBM is Worth $236

The stock price of International Business Machines (NYSE:IBM) has been in a downward spiral since the past six months and its price has declined by approximately 15% to $183. IBM’s margins have improved considerably due to its focus on high margin businesses such as cloud, while its revenues have declined in the past few quarters. This decline in revenues has contributed to the negative sentiment among investors.

Currently, we estimate IBM’s stock price to be $236 and believe that the recent efforts taken by the company will positively impact its long-term growth potential. In its 2015 roadmap, the company stressed that it was focused on big data analytics and cloud computing services. This strategy is yielding results as the company is witnessing robust growth in revenues from these initiatives. Furthermore, its middleware offerings continue to gain traction. Additionally, the company has undertaken cost cutting measures that will help it to improve its bottom-line. In this article we discuss key factors that contribute to our belief in IBM’s long-term potential.

Cloud services are transforming business solutions globally and companies are leveraging technology to offer new and improved services across traditional and new channels. IBM has spent billions of dollars building its cloud business globally with a number of acquisitions in the past three years that includes Trusteer, Softlayer, Keneax, DemandTec and Sterling Commerce, etc.

According to IDC, the cloud Software-as-a-Service (SaaS) market is poised to grow from $22.9 billion in 2012 to over $67 billion by 2016. The research firm also predicts that SaaS will achieve a compound annual growth rate (CAGR) of 24% through 2016. [1] Furthermore, IDC expects the Infrastructure-as-a-Service (IaaS) market to grow from $12 billion in 2012 to over $38 billion by 2016. Gartner predicts that IaaS will achieve a compound annual growth rate (CAGR) of 41.3% through 2016. However, the total addressable market (TAM) for cloud services is estimated to be around $340 billion. [2]

IBM’s technology services (GTS) and global business services (GBS) divisions together make revenues of nearly $60 billion and account for 35% of its estimated value. In the past few quarters, IBM’s cloud initiative reported growth of over 70% and is the primary reason for IBM’s revenues stabilizing in its technology and global business services division. IBM projects that cloud services will generate $7 billion in revenue by 2015, but we estimate that the top line will be meaningfully higher due to the acquisitions and initiatives that IBM has undertaken in the past few years. We expect that most of the gains in GTS and GBS revenue in the future will come from growing cloud services. Currently, we forecast that GTS revenues will grow to $42 billion and GBS revenues will grow to $22 billion by the end of our forecast period.

IBM Leads The Middleware & Software Market

The Middleware division together with Operating Systems division is the biggest contributor to IBM’s stock value and makes up nearly 55% of our estimate. This division has witnessed robust growth in the past few years, and currently accounts for over 45% of IBM’s pretax income.

According to Gartner, IBM is a leader in Mobile Application Development platforms, On-Premise Application platform, Application Services Governance and On-Premise Integration. [3] Many of its solutions such as WebSphere, Rational Suite, Tivoli cater to the growing markets that include mobile, social, cloud storage and security tools. We expect that the company will continue to post robust revenue growth in the future as its clients continue to favour IBM solutions for their middleware and application development needs. Currently, we project that middleware revenues will grow to $25 billion by the end of our forecast period, with new licenses contributing nearly $7 billion to it.

Restructuring To Improve Margins

In the past few quarters, the company has been restructuring low margin outsourcing contracts to boost profitability. Furthermore, the company has embarked upon a “workforce rebalancing” or job cuts to improve its profitability. This strategy yielded results as the company’s gross profit margins improved by 170 basis points to 39% y-o-y in Q3.

Most of the company’s cost cutting measures are centered on the ailing system and technology. This division has lost close to $700 million in CY13. If IBM can stem further declines in these underperforming divisions, margins for the company can improve. Currently, we project that these efforts would improve IBM’s EBITDA margins from 12% in 2012 to 13.6% by the end of our forecast period due to these efforts.

Comments

I agree with this valuation. I believe that IBM needs to have the CEO and new CFO confirm that they are still on target to meet the year end 2015 road map of $20 per share. With an outlook of year end >$16/share and a reasonable price multiple of 15, IBM should be valued now at $240.

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